Variable cost. You may have heard it in your accounting class or you may have seen it in your financial statements. If you’re a business owner, it is very important to get to know what it is and how it impacts your business. You see, there are two types of costs - fixed cost and variable cost. Each one plays a role in your business. Knowing how to manage each one can help drive your profits up and keep your costs down to a minimum. It may be good for your investors as well if you are encouraging them to invest in your business.
In this article, you’ll learn more about the different types of costs with the focus mainly on variable costs. You’ll also learn how to understand variable cost and how to manage it for the positive growth of your business.
Before I discuss variable cost in detail, here are some of the key terms that you must first understand.
Fixed costs are called as such because they don’t move. It is fixed because they don’t fluctuate on a monthly basis. With it, you know what to expect. Month after month, you can expect to spend this amount of money to continue your operations.
A perfect example of a fixed cost is overhead. This is the amount that you pay your employees month after month. As you can see, it is fixed for it doesn’t and is not expected to change.
The same is true with rent. If you are renting an office for your business or you are renting a commercial location to continue operations, you can expect that you will pay for the monthly rent month after month. This is also a good example of fixed cost.
Another not-so-obvious example of a fixed cost is depreciation. This is the amount of money that you lose as your PPE (plant, property or equipment) depreciates over time. Any equipment has a depreciation value. This means that its worth is lowered the more it is used. This is an estimate that is deducted to the cost of the equipment on a monthly basis. Although it not paid in the physical sense, it is still considered as a fixed cost.
Another definition of a fixed cost is the type of cost that you must pay regardless of your profits. This means that it doesn’t depend on the amount of products that you have sold. Whether you sell or don’t sell, you still have to pay your fixed cost. In that sense, it is ‘fixed’ because it is not dependent on any other variable.
Can you reduce fixed cost? The answer is ‘Yes’. In fact, it is highly recommended. The problem with fixed cost is that it continues over the long term. And it can affect your balance sheet negatively.
So how can you reduce fixed cost? There are several ways. One is to rent a less expensive location. Another is to reduce the number of employees that you have. You can also delay the schedule of the depreciation of your equipment. It all depends on you and your accountant’s creativity.
Now this is the star of this guide - variable cost. It is called as such because it moves with your revenue. Unlike fixed costs that is expected to be paid regardless of the performance of your company. Variable costs are paid based on your revenue. With this, variable costs increases as your revenue increases.
Variable costs play a more active role in production. Let’s say that you are a car production company and you got 15,000 orders of cars. The materials that you will need will depend on the order and so will your seed money. This ‘seed money’ is a type of variable cost. This fluctuates based on the number of orders and can change on a monthly basis.
Lowering variable cost is easy. You just need to either buy less of the products that you need to manufacture an item or you can lower the price of the item that you are buying. This is the reason why companies (even bigger one) are on the constant lookout for new suppliers. If they can find suppliers that can give them a lower cost, that will greatly reduce their variable cost.
Other types of variable costs include commissions, salaries, shipping charges and delivery charges. These can fluctuate based on the demand and the number of sales your company is able to do in a given month.
Cruising along the middle of fixed costs and variable cost is a term called semi-variable cost. They are called as such because they have the combined characteristics of the two.
A good example of this is wages. The wage of a permanent employee can be considered fixed. But the company can also replace the employee anytime. And if the wage also includes commissions, it is really a semi-variable cost. That’s because it means that there is a fixed monthly wage along with commissions depending on the performance of the employee.
Another example is depreciation. While I had tagged this as variable cost, it can become semi-variable when it is dependent on the equipment’s usage. There is such a computation and it can transform this variable cost into a semi-variable cost.
Variable Cost Ratio
In accounting, there is a term called variable cost ratio. This is an expression of the company’s variable costs over sales revenues. The product is the percentage of sales that is attributed to variable costs. This shows how much of the revenues are really considered as profit and how much goes back to the company for operations.
Why is the variable cost ratio important? Well, ratios are used to assess a company’s performance. In this instance, it indicates the level of profitability the company has. It is how balanced the company is in incurring expenses and generating profits. In essence, it is a quantity that can be seen how variable costs relates with revenues.
Where can you use variable cost ratio? Well, it is a very important element in pricing. With it, you’ll be able to determine the right price for your products and services so that you can continue making a profit.
How it All Works Together
You cannot understand variable cost if you will look at it in isolation. With this, you also need to consider different elements in your financial statement such as revenues, contribution margin, costs, sales volume and profits.
Revenues are the money that comes in your business. Costs are not yet deducted to this. It is just the total money that flows in.
Costs are the money that comes out of your business. This is the money that flows out. This can either be direct such as production and labor costs. It is called ‘direct’ because they have a direct impact in the final product. Or it can be indirect such as rent and insurance. It is indirect because they don’t directly contribute to the final product.
Sales volume is the number of sales you have done in a specific time period. You can set this monthly or every 3 to 6 months. It all depends on the type of report that you need.
The profits is the revenue minus the cost. This is the money that your business has earned. It is the difference between the money that goes in and the money that goes out.
Then, there is contribution margin. This is the percentage of total sales revenue over total variable costs. This is the opposite of variable cost ratio that I have discussed a while ago. This aims to measure what part of the revenue can go to fixed costs and profit.
Here’s how they work together. Costs changes your profit. If costs go down, your profits go up. Similarly, revenues also affect your profit. If revenues increase, your profits also go up.
This is also true for sales volume. Sales volume positively affects profit. As you have more sales volume, your profits go up.
However, sales volume plays a role in variable costs. Variable costs depend on sales volume. The more sales you have, the higher your variable cost will be.
What is Fixed and What is Variable?
So how can you determine if a cost is fixed or variable? Well, there is no direct answer to that. In fact, it depends.
For example, staff wages as I have mentioned are considered as semi-variable because they can be fixed (as with a permanent staff who works 8 hours a day, 7 days a week) or it can be variable (as with a call center agent who earns commissions for each sale). Again, it depends on the nature of the work. In outsourcing for example, the cost can be tagged as variable for the staff is not considered permanent and is on a perpetual contractual basis. Also, there are staff workers who only ‘help’ when you’re busy. These are your part-timers who often work daily or hourly. These people’s wages are then considered as a variable cost for it is not expected to be paid month after month.
Another example is depreciation. Depreciation is an estimate or imaginary value that you lose as you continue to use an asset or plant, property or equipment over time. This is because these items ‘degrade’ in value as time passes. So that can translate to you ‘losing’ money on a monthly basis. With this, it is considered as a fixed cost. However, once usage is considered as a factor. Depreciation now depends on sales volume (or usage). If you take this into consideration, depreciation then becomes a variable cost.
Pros and Cons of Fixed and Variable Costs
Fixed costs are great because they are expected. Once you see them on paper, you know that you will be paying that amount month after month and you can start getting ready. These constitute long term deals so you don’t have to worry so much about the price changing ever so often.
The problem with fixed cost is that they are not dependent on sales volume. In fact, it doesn’t even care if you sell or not. Regardless of performance, you have to pay it. This can ‘hurt’ if you are starting out and you don’t really have the money to spare.
Variable costs are great because they can be removed from your costs if you are not busy. This means that they can be removed as a category. The problem with this is that it changes often. Since you are not consistent and you are not willing to have long term deals, this may not be good for negotiations.
How Can You Lower Variable Costs for Your Business
Now that you understand what variable costs are, it is time to lower them. Here are some tips on how to do that.
Always Ask for a Quote
Start approaching your suppliers by asking for a quote. If you’re new to the business, don’t be afraid to approach different suppliers at the same time. Introduce yourself as a company that has continuous business so that you can haggle the prices down.
Negotiate with Suppliers
When it comes to costs, the lower, the better. So be sure to don’t take the first price that your supplier gives you. I am not saying that you should haggle it to the lowest you can get it, but you should at least use your negotiation abilities to get the best long term price for your business.
Ask yourself if you really need to spend on it
Variable costs come from supplies. But is the item really necessary? Make an audit and think about it. If you can remove it and lower your cost, then do that.
So that’s how you can use variable cost to power your profits. Have you sat down and looked at your variable costs closely? How much are you currently earning? How can you lower your costs to drive profits?
I hope you liked this guide. Feel free to ask questions in the comment section below.